What caused the Great Inflation? And what might bring it back?

IF YOU were to draw the path of inflation in the typical big, rich economy over the past half century, your picture would look much like a dromedary's back: a low flat line in the 1960s; a knobbly hump of high and volatile price rises in the 1970s; dramatic disinflation in the 1980s; and low, stable inflation rates since. Japan and Germany, which were quicker to quell inflation, are well-known exceptions. But for the rest, the shape and timing of the Great Inflation bulge look remarkably similar.

This is a bulge that today's central bankers are anxious not to repeat. So it is no surprise that several governors from America's Federal Reserve are attending a conference on March 9th to discuss a new report* on the Great Inflation, written by a weighty group of macroeconomists from academia and Wall Street.

Most scholars agree on a basic explanation of the hump, placing both blame and credit squarely on central bankers. Consumer prices accelerated in the late 1960s because monetary policy was too loose. German and Japanese central bankers realised this earlier than others and tightened policy accordingly. Eventually others followed suit, and general disinflation began in the early 1980s. Since then inflation has stayed under control because central bankers are credibly committed to price stability and far better at their job.

Beyond that broad tale lie several debates about important details. Economists differ on how much non-monetary phenomena, such as closer trade integration, affect the inflation process. They also offer competing explanations for why central bankers botched things so badly a generation ago. One possibility is that they simply got the numbers wrong, consistently overestimating their economies' speed limits. Others blame theoretical misjudgments, particularly the belief that higher inflation could buy a lasting drop in unemployment. A third approach emphasises political pressure. Inflation got out of hand because central banks were under the thumb of politicians who preferred rising prices to higher joblessness.

In this latest report the authors subject such controversies to painstaking cross-country forensics. They show that price stability across the G7 countries has been far more closely correlated than economic stability. Almost everywhere, inflation took off between 1969 and 1970. And every country, except Germany and Japan, failed to tame it until the mid-1980s. Output, however, was less tightly synchronised. Although recessions in many countries have become less wrenching in recent decades, output volatility began to ease in the mid-1980s in America, but not until the early 1990s in Britain, Canada and France.

What to make of these differences?

The Great Inflation, because it was felt simultaneously across countries, must have had a common cause. This cannot have been the 1970s oil shocks, because consumer prices started accelerating long before the price of crude did. Easy money is the only remaining suspect. And although the Great Disinflation was also simultaneous across many countries, GDP growth settled down at very different times. This implies that better monetary policy cannot take full credit for today's less painful recessions.

The statistical magnifying glass also casts doubt on some favourite alibis for monetary misrule. Bad data, for example, do not get central bankers off the hook: revisions to statistics on trend growth and unemployment were not big enough to excuse the scale of inflation. Instead, monetary policy was simply too loose. The authors show that the central bankers of the 1970s failed to adhere to the modern “Taylor rule”, a formula that links the appropriate level of short-term interest rates to the deviation of output from its trend and inflation from its target. Of course John Taylor, a Stanford economist, did not formalise his rule until 1993. But even without this guide, central banks should not have flunked the basic tenets of sound money.

Neither the Taylor rule, inflation targets nor any other bits of the modern central bankers' toolkit were necessary to end high inflation. But the scholars think these tools have helped to keep inflation down, which, in turn, has spawned a virtuous circle. When inflation is low and stable, a temporary uptick in consumer prices has far less impact on long-term price trends. The economists' model implies that less than 1% of a temporary price surge is translated into a permanent rise in inflation today, compared with 60% three decades ago.

That may give today's policymakers more leeway than their predecessors enjoyed. But since this wiggle-room is the legacy of low inflation volatility, it cannot be taken for granted. Were central bankers to lose their guard, inflation could soon resurge.

More worrying, the economists pour cold water on many a policymaker's favourite gauge of his own performance, namely the public's expectations of future inflation. Central bankers often cite low inflation expectations as evidence that monetary policy is appropriate. That may be a mistake. This paper argues that expectations were a good guide to future price pressure only when inflation was high. But now, if anything, inflation expectations are a backward-looking indicator, lagging measures of actual inflation. [Actual Inflation Rate = Expected Inflation Rate + Constant x (Actual Unemployment Rate – Natural Rate of Unemployment) The actual inflation rate is dependent on two factors: the expected inflation rate and the unemployment gap (the difference between the actual unemployment rate and the natural rate of unemployment)].

All told, this statistical sleuthing suggests today's central bankers have little room for complacency. Inflation remains low and stable because policymakers are vigilant, not because any deep, structural changes insulate the modern economy from price pressure. If central bankers relax, higher, more volatile inflation could easily return. Rudyard Kipling's camel, remember, got its hump for being “most 'scrutiatingly idle”.